Making It Easier to Manage the Transition From LIBOR to RFR and SOFR
The end of LIBOR (London Interbank Offered Rate) is rapidly approaching. The world’s most widely referenced interest rate benchmark, underpinning hundreds of trillions of dollars of notional value of bonds, mortgages, derivatives, and other products is being phased out through 2021 and 2022. Current LIBOR products are migrating to reference overnight risk-free rates (RFRs), such as the Secured Overnight Financing Rate (SOFR) in the US dollar market.
Financial institutions with positions linked to LIBOR are faced with two challenges: first, updating their risk systems to support products linked to RFRs; and second, estimating and implementing the impact of LIBOR terminations on their existing portfolios.
This transition has the potential to introduce significant amounts of risk and uncertainty and even temporarily disrupt business. Front and middle office professionals will have to price and manage RFR-linked positions as liquidity moves away from LIBOR-linked products. Perhaps more challenging, they must evaluate and evolve their fixed income and derivative portfolios position by position when a LIBOR termination occurs.
Beacon is automating the transition
Beacon has developed innovative functionality to help deal with both of these challenges.
First, we added support for RFR-linked securities and derivatives, from standard fixed/floating swaps, through floating rate bonds and more complex products like interest rate swaptions that are designed to settle into LIBOR-linked swaps. Beacon’s financial instruments know how to price and evolve themselves through lifecycle events, rate fixings, and other operational events; and they can be used as inputs into Beacon’s interest rate bootstrapping analytics, so that they can be priced at market and represented properly in risk and attribution calculations.
Second, we added functionality to evolve existing LIBOR-linked products into RFR-linked products—both for derivatives that fall under a consistent ISDA framework for fallback, and for the more complex problem of fixed income assets which have bespoke legal agreements and fallback provisions. This logic allows Beacon clients to seamlessly handle LIBOR termination events when they happen. But it also allows them to run what-if analytics to look at different potential LIBOR termination scenarios and estimate the mark to market and risk impact on a portfolio in advance of an actual termination.
This automation dramatically reduces front and middle office effort for financial institutions to manage their book as LIBOR is phased out.
Supporting both derivatives and fixed income instruments
Adding support for RFR-linked derivatives, both as tradable instruments, as inputs to yield curve bootstrapping analytics, and as risk axes, is addressed with Beacon’s dependency-graph-based financial object models. These models are designed to make it easy for Beacon—or its clients, in Beacon’s buy and build on top development framework—to add new types of analytics, products, and risk measures.
Building lifecycle evolution functionality for LIBOR-linked derivatives was also a standard extension to existing behavior. Since Beacon financial instruments know how to evolve themselves through lifecycle events, the LIBOR-RFR transition was simply added as a new type of lifecycle event. Derivatives are simpler than fixed income because they fall under a consistent ISDA legal framework—so all LIBOR-RFR transitions follow a single set of rules.
More complex was managing the evolution of fixed income instruments, because there is no consistent legal framework that defines the LIBOR-RFR transition for all such instruments. Instead, each instrument’s legal documentation defines a bespoke transition. In practice, almost all such transitions fall into a small number of categories. Beacon implemented a framework to tag each fixed income instrument with the appropriate category—which then allows automated evolution through a LIBOR termination, and using the same tools makes it easy to run LIBOR termination scenarios in advance of a real termination.
At the initiation of this project we were concerned about what could potentially be a large number of different flavors of LIBOR fallback logic in the multitude of fixed income product legal terms. When we looked at real client portfolios we were pleasantly surprised to find that the number of such categories is relatively small, typically just three or four. This small number of categories makes the manual part of this process—having to tag fixed income instruments with the appropriate transition category—easier and less prone to error.
Automating transitions dramatically reduces the business effort
Automating the LIBOR-RFR transition logic makes it straightforward to quickly game out the impact of different transition scenarios, without any manual effort beyond tagging fixed income instruments with the appropriate transition category. Without this automated transition, institutions face significant manual work to estimate mark to market and risk impact of the transition, plus operational overhead to rebook all the evolved positions.
Our solution supports financial institutions’ needs to trade and manage RFR-linked products as liquidity moves from LIBOR-linked to RFR-linked products—both as standalone trades and as inputs to yield curve bootstrapping that feed pricing and risk analyses.
Even more substantially, Beacon’s LIBOR-RFR transition logic supports uncertain termination schedules, automating both the pre-transition scenario analyses and the actual evolution of the portfolio through termination events. Beacon’s clients are using this functionality today to price and risk-manage RFR-linked products and prepare for LIBOR termination events by running automated termination scenarios on their portfolios.